Anything you can do I can do better!
Pure Storage (NYSE:PSTG) and Nimble Storage (NYSE:NMBL) are the current enfant terribles of the enterprise storage business. They were both formed about a decade ago to provide flash storage arrays in competition not just with each other but almost every storage vendor who has ever walked the earth. (At this point Nimble and Pure are really only competitors in that they both provide flash storage products. It appears that over time that they will become competitive but that is not quite the case these days. But many investors seem to consider them in the same context and so I think it makes sense to include them in the same article. And so while the article is a bit long, readers get to learn about two companies for the price of a single read.) The lead in is the title for a song in the Irving Berlin hit of 1946 called 'Annie Get Your Gun' which was one of the showstoppers of that very successful musical.
When I originally composed this sentence, I wanted to say that flash is the hottest trend in storage since the last one. But that really isn't the case. I first got into the IT business working for IBM right after the dawn of spinning discs. Spinning discs are a mechanical product that has the limitations and constraints inherent in all mechanical products. Flash marks a transformation of the same magnitude that spinning disc represented when it replaced tape at the start of my business career. Spinning discs are on a course to sunset in the next few years and the market will be more transformed by that time than has been the case since NetApp (NASDAQ:NTAP) came into the market in the 1990's with network attached storage (NAS) but this is a far more basic transition than that ever proved to be.
Nimble share valuation is significantly cheaper than Pure and there are many reasons for that. The company, at least thus far, has shown a less distinct path to profitability although there are signs of improvement in the last couple of quarters. It entered the market for what are called all-flash arrays (AFAs) just a few months ago and its growth trajectory is certainly less well-established than that of its larger rival. For some years, its focus was on a hybrid flash product which is probably on the road to obsolescence. It may have entered the lists for AFA just in time and its latest forecasts call for growth to re-accelerate.
Going back many years, there has never been a low-risk way of investing in the enterprise storage space. At one point, at the dawn of the internet, EMC was one of the so-called four horsemen companies and was priced as though it would never face competition. After that myth got shattered, NTAP was the poster child in the storage space for a while and achieved rapid and profitable growth for many years with a valuation to match. Then there were the companies in the deduplication space and those that pioneered scale-out NAS architectures. As readers will see shortly, flash came along a few years ago and many of the original companies in the space flamed out and were acquired in deals that proved to be very disappointing.
Personally, I think investing in companies with disruptive technologies tends to be a fraught experience at best. Many investors just don't like having to bet so much on the come. And the fact is that the legacy companies in this space have been around for many years and are many times the size either Nimble or Pure. And this transformation is not quite like the mass extinction event when the meteorite that did away with the dinosaurs 65 million years ago and made room for our species. These dinosaurs will most likely survive in some fashion; some of them may even thrive to one extent or the other.
One of the issues in investing in companies that sell enterprise storage is that there is always an element of commoditization and always issues with regard to price competition. No one buys storage of any kind for any reason other than some kind of quantitative analysis regarding cost. Storage doesn't look pretty and you can't get a thrill watching it accelerate from 0-60mph.
The trick in selling storage is to be able to provide users with an experience that can resolve some of the inevitable issues with regard to price competition. There is some evidence that Pure has pulled that off and will continue to do so. It is not an impossible feat; NetApp enjoyed a very long run, enjoying high-gross margins and premium pricing but management eventually forgot how it got to that point. I think that the shares of PSTG are reasonably valued with an EV/S of just greater than 2X. Further, as I discuss below the company has a realistic path to profitability and that the company has achieved a relatively strong degree of differentiation that is likely to persist into the future. Overall, while Nimble shares are cheaper, I am not nearly as certain as to its future. I think if investors are going to invest in companies selling disruptive technology they may as well take the plunge all the way and focus at least as much on growth as on current profitability. But the fact is that with Nimble, investors get less growth and still are investing in a loss-making business. It doesn't quite add up for me when comparing the investment to buying PSTG shares.
Needless to say, at the moment, neither Pure nor Nimble are profitable and that is true even on a non-GAAP basis. They both lose lots of money and they have burned some amount of cash. Growth has slowed markedly for Nimble but seems to be making a modest comeback. Pure has forecast slowing percentage growth but that certainly hasn't happened the last two quarters and it may have under-forecasted user appetite for the flash transition.
Nimble shares have performed worse than those of Pure. Since the company's IPO back at the end of 2013, it has lost 77% of its value. Since Pure went public about just less than a year ago, it has lost just 19% of its value and it has had a significant rally of 20% over the past three weeks. Nimble and Pure really do not quite compete with each other. Their products are aimed at different corners of the storage market and the companies are not seen as alternatives. But they both use what is called flash technology to build their storage arrays and they are two of the three survivors of the flash craze that remain as independent vendors. (The third, Violin Memory, (NYSE:VMEM) is really in extremis and will almost surely wound up getting liquidated for little or no value.
There is often a certain cadence that often appears in the life of a tech IPO. It starts out with valuations that reflect what might best be called a scarcity value as they cannot be justified by any real metrics that investors typically use. They are just "Too darn Hot" a famous song by Cole Porter from the show Kiss me Kate, itself an adaptation from Taming of the Shrew by William Shakespeare. And then, most often, the shares seem to "Doin' what comes naturally," the title of a song from the musical Annie Get your Gun by Irving Berlin & writer Dorothy Fields and go through some major valuation compression.
The question is really what comes next. What is the logic between thumbs-up on PSTG and a neutral evaluation of NMBL? Can either or both of the companies find some realistic path to profitability in a very crowded market? Does either company have the potential to overcome the huge headwind that is the cloud that has made the enterprise storage business a graveyard for investor hopes?
It will be these topics that I will try to explore in the foregoing article.
By the Numbers - Some Compares and Contrasts!
I suppose it would be nice for readers and it would certainly be nice for this writer if I could just gloss over this section. But I think undergirding any investment is a detailed quantitative analysis and here, in comparing two different companies, that comparison just simply has to be based on lots of numbers.
Pure is quite a bit larger than Nimble with an enterprise value of about $2.1 billion compared to an enterprise value of $440 million for Nimble. Neither of the companies is in any danger of achieving profitable operations in the near future. They both happen to have fiscal quarter that end one month after calendar quarters. Pure has got a bit more than $570 million in cash and no debt. GAAP losses have shrunk significantly both year on year and sequentially. The company's cash burn has moderated substantially although it is still was above $10 million this past quarter, a step backward from the company's Q1 results. The company is forecasting consistent cash flow from operations in its next fiscal year and current trends suggest that the forecast is based on reasonable expectations.
Stock-based comp at 16.6% of revenues last quarter is still rising substantially, up more than 100% year on year and 17% sequentially. The growth of deferred revenue has not been consistent in terms of its percentage but as the company gets larger, I would expect that most of its customers will choose an annual maintenance billing option that will make that metric more predictable and less random in terms of its pattern. There have been signs of leverage at scale, and those signs were significantly stronger last quarter than in the recent past. That said, however, management told investors on the last call that its results were assisted by unplanned inability to spend money - perhaps not such a terrible problem. Investors were cautioned to avoid thinking that profitability was just around the corner. I don't think that was a terribly alarming potential.
Nimble's EV/S is down to just a bit more than 1X based on current-year estimates of 24 analysts. And its growth rate is down to less than 25% for the current year and 21% for next year. Pure's growth rate is estimated at 63% for this year although it was over 90% last quarter. I am not too sure how serious Pure's current year revenue estimate actually might be. Pure forecasts its revenue growth just once a year and that is what the consensus reflects. The fact is that both quarters so far this year have been significantly above the company's forecast without any adjustment in either guidance or estimates. The current quarter has an estimate that is supposedly tempered in terms of growth percentage because of a specific issue that drove results for the year-earlier Q3 significantly above plan.
But so far this year, the company has achieved 92% growth and is forecasting growth to decelerate to 47% this quarter. Based on the recent track record, that seems to be more than a bit conservative. In any event, using the consensus estimate, Pure has an EV/S based on this year's estimated revenue of $717 million and an enterprise value just greater than $2 billion of 2.9X and an EV/S of 2.1X based on estimates for fiscal year 2018 that ends on 1/31/18. As will be explored below, there is massive investor skepticism that Pure can find its way to sustained profitability amidst the sand bars and shoals of the enterprise storage waters.
Overall, Nimble's path to profitability appears more measured to this observer, and its growth rate, while starting to show favorable trends based on new product introductions, is far lower, and far more at risk than is the growth rate of Pure. The company's GAAP losses have shown some modest signs of decreasing in the years since the company has been public, and the trend continued last quarter at a slightly faster pace. Some of that is the result of favorable gross margin trends that have been brought about because of product mix. Some of the improvement relate to control of general and administrative spending. But the other components of operating expense such as research and development are taking a long time to control. On the call, the CEO Suresh Vasudevan and CFO Anup Singh did everything in their power to avoid answering specific questions in a quantitative fashion when it came to margins. It makes it harder than it should be to guess about how long it will take for the company to reach profitability.
The company has $195 million in cash and no debt. That puts the company's enterprise value at just less than $435 million. With revenues estimated to be almost $400 million this year and $482 million next year the EV/S metrics are just a bit greater than and a bit less than 1X. Most analysts raised estimates in the wake of results for the quarter that ended on 7/31 but those kinds of valuations reflect more than a bit of skepticism regarding viability. They are also at levels that have to invite speculation about the company being a candidate for consolidation by either private equity or from one of the many strategic participants in the enterprise storage space. Trying to handicap the evolution of price wars on into the future is certainly a fraught exercise, and one made more difficult when considering that this company is likely to have lower product costs than its larger competitors as reflected by its gross margins that are 65% GAAP and 67% non-GAAP. Gross margins were essentially consistent in the past quarter and compared to 65.3% non-GAAP gross margins in the year-earlier period. It is relatively plain that this company, along with Pure, enjoys substantial cost advantages when compared to legacy vendors who have far lower gross margins probably reflecting both lower average selling prices per unit and higher manufacturing costs for their very old designs.
The company's results have been hovering right around break-even in cash flow for several quarters. Last year, it generated cash; this year it has burned some. The amounts are not particularly material and for what it is worth, Q2 showed an improvement at the margin when compared to Q1.
Have valuations for these once high-flyers just been doin' what comes naturally, i.e. compress or is there some substance to make them worthwhile as potential investments. It is relatively clear that the valuations have compressed by more than might be attributable to the normal course of hyper-valued IPOs. Concerns regarding competition and particularly price wars are rampant. I think those concerns are likely to prove overblown, particularly when the aggressors in the price war have inherently higher product costs than these two smaller competitors due to older, less efficient architecture. While the current lack of cash flow may preclude sale to some private equity bidders of either Nimble or Pure, there are many operating entities, including most of the large old-line server companies who might be able to reap lot of cost and some revenue synergies. That is probably most true for Nimble which is more of a specialist niche vendor than is the case for Pure and has a valuation that usually attracts bidders like crazy relative to many other valuations.
The storage space and flash - a bit of background
There have been many trends in the IT world that have come and gone through the years. One set of constant trends, however, has been the extremely rapid growth of storage demand in most user installations coupled with the extremely rapid degradation in price per unit. If there is nothing surer in life than death and taxes, there is nothing surer in an IT installation than the need for more storage capacity and the availability of more capacity at a lower price per unit. This article is not the place to discuss the growth in storage demand although I have to touch on issues with regard to price elasticity and the cloud at least on the periphery.
For many decades, spinning discs have been the technology that has been used to provide storage to users. The leading vendor in the space has been EMC although lately statistics suggest that Hewlett Packard Enterprise (NYSE:HPE) has been giving it a run for its money. But with the consolidation between EMC and Dell now underway, it is certain that the new entity will be the king of the market share hill both now and for some time in the future. Rivals that are included by both Gartner and IDC in their evaluation of the enterprise flash market space include NetApp, IBM (NYSE:IBM) other than those mentioned above also include private vendor Kaminario. Over the years, several smaller vendors have been consolidated.
At the turn of the decade, the industry was vastly disrupted by the emergence of what are known as solid-state drives (SSDs) or flash. (There are industry observers who want to confuse things by putting the two terms in different buckets but the best definition I have seen is that solid-state drives are simply a disk without moving parts while flash is the implementation that allows this to happen. I will use the two terms interchangeably in the balance of this article.)
All of a sudden, there were legacy vendors who had led the market in providing spinning discs and a new wave of vendors who furnished the market with enterprise-grade flash. It has been an interesting evolution to watch. One of the leading storage vendors, NetApp, was almost wiped out when its management held out against providing users with all-flash storage arrays. EMC bought a tiny flash storage company called DSSD for $1 billion because it sat above EMC's XtremeIO flash offering on performance graphs for SSDs. 3Par, which HPE had acquired in the midst of failing financial performance by that vendor, turned out to have flash technology that has been able to support HPE's storage market share. Fusion-io, which had been the largest independent company selling flash memory was bought by SanDisk (SNDK) a couple of years ago in the midst of what appeared to be a financial flame-out. IBM entered the market in 2012 when it bought Texas Memory Systems. I expect that IBM would not be in the storage business at all were it not for the need to support its server offerings. That said, if it has to sell storage, it can certainly find better storage to sell than that which it currently offers.
The enterprise storage space these days is a large market, but one that is no longer growing. According to IDC, in Q1, the market declined by 7% overall to a run rate of $33 billion. Pure, on its recent conference call said that its addressable market was $24 billion. Market shares have shown a significant reshuffle based on which vendor has a superior flash product line. At the moment, perhaps to the surprise of some, Hewlett Packard is now in 1st place having overtaken EMC. As mentioned earlier, the combination of Dell and EMC is likely to be in 1st place once the product lines are consolidated. This year, more than 50% of the enterprise storage market will be flash according to IDC.
PSTG is taking share in the enterprise storage space at a huge rate. Other share gainers are HPE and Huawei. Nimble competes in a far more specialized space that is self-limited at this point but it too is taking share within its defined space, again in the context of a declining market.
Simply put, while the demand for storage capacity continues to rise significantly, the cloud is having a major impact on the demand for overall enterprise storage. In addition, the capability for data reduction that is possible with flash is considerable. (For readers unfamiliar with the term as it is currently used by many analysts, data reduction is the transformation of numerical or alphanumeric digital information derived empirically into a corrected, ordered and simplified form. Data reduction includes both deduplication and compression and both are incorporated in the Pure offering to a degree beyond that offered by other, competitive vendors.)
The data centers that users used to grow, almost as though they were marijuana plants, are becoming a relic of a bygone era and more and more storage is coming to reside in the cloud. In addressing the outlook for Nimble and Pure, the questions on which to comment relate to their market share gains and their sustainability and that in turn relates to their ability to deal with the cloud-both public and private.
Can Pure survive the bloodbath that is emerging in the storage space?
Most readers just want to know if PSTG is a good stock to buy and to hold and they do not want to worry about the technology. But this is one of those particular situations in which understanding the technology, at least superficially, is really necessary in order to try to answer the question. The simple answer to the question is that not all flash drives are created equal and that Pure has flash technology that affords users significant advantages in terms of functionality that are unavailable from legacy vendors at this point. That is no doubt a statement that would find controversy amongst analysts but I have to use the objective material that is at hand. Pure is rated first by Gartner and tied for first by IDC. And it has an unprecedented user satisfaction score as reported by IDC - one that is far beyond that of its competitors. Since I do not buy or use storage I have to rely on the resources of third-party consultants. There are obviously going to be other opinions on the subject of who is offering the best price/performance or the potential that Pure's position could get eroded in the future - but for now the surveys show what they show. It would be hard to imagine under the circumstances for Pure not to gain market share at a substantial rate.
When flash appeared on the scene, it presented legacy vendors with some significant challenges. For those readers with a recollection of history, it was more or less the same thing as when Britain launched its first Dreadnought in 1906. The dreadnought class of battleship was the ultimate fighting platform of its age and would soon lead to a mutually destructive arms race between Britain and Germany that was part of the background as to the casualty of WWI. Everything that had come before in terms of warships was instantaneously obsolete. Today, of course, there are no more battleships although if a reader goes to the San Jacinto monument outside of Houston, which is a memorial to the fight of Texas to free itself from Mexico and the battle that was fought on the site, you can still see the vessel as it has been completely restored. Depending on how fast one wants to drive, it is around one hour from the Galleria (the large shopping center on the west side of Houston to the monument.
After years of working to perfect disc arrays that were faster and could be better deduplicated and generated less heat and used less power and so forth, the storage world had been turned on its head. The companies that had been the leaders in the storage market for many years are now the ones trying to catch up. At the moment, and for at least some time into the future, the race is to the "Pure."
Pure's design these days incorporates several major functional advantages. I do not propose to go through how Pure delivers what it does - and I doubt if I would do the technology justice but the company has allowed users to break the typical cycle in which storage has to be bought anew every 2-3 years as old arrays reach their capacity limits. What PSTG describes as its "Evergreen" program is quite dissimilar than the way users wind up buying flash from legacy vendors. There is another basic concept in the world of storage called data reduction. It is a way of minimizing the amount of data that users have to store. One reason that the growth in storage shipments has come to a halt is that as flash becomes predominate, users need less of it to get the same results. It isn't that the growth rate in required storage capacity is slowing but that the need for capacity is being obviated, to an extent, by technologies that compress and deduplicate so that users wind up getting the same amount of storage capacity even though they have less storage than they would have needed a few years ago. Depending on workloads, the PSTG data reduction is several times more efficient than the flash arrays that are sold by legacy vendors and there are fewer snap shots that need to be taken. While it doesn't always work out on a one-for-one basis, many use cases will require less actual Pure storage than is the case with legacy vendors. It is the same concept that NetApp used to sell when it pioneered storage efficiency many years ago.
Price wars are not going to go on indefinitely in the storage business as their results wind up being too painful for most vendors to sustain. In order to take some pressure off of current reported results, vendors frequently will heavily discount maintenance, they will provide a couple of years of free maintenance and they will bundle their offerings in order to provide users with what is notionally the "lowest" price. Much can be written about all of the different tactics in today's storage price wars; at the end of the day, selling products below their cost no matter how artful are the concessions in terms of reducing the reported impact in the initial year just cannot be sustained. Recommending or not recommending a stock like Pure is a bet on just how long and with what degree of intensity "excess" price competition might last. Does Dell eventually decide that it needs to generate cash and reduce its debt mountain or does it continue to try to put genies back in proverbial bottles? I am guessing the former - but other readers may disagree and I can't say that Dell, in particular, won't continue on its current path.
The issue of market share is one that comes up in investment discussions regarding PSTG as a major factor in the company's valuation. The company's latest quarter showed growth of 93% year on year and 16% sequentially. The company is forecasting $191 million of revenues for its current quarter, which would be growth of 46%. And the consensus for next year, based on the estimates of 24 analysts shows growth of 40% with revenues of just above $1 billion. There is probably some upside in those numbers as they are essentially consistent with the dollar growth in sales achieved this year. The company's FlashBlade release is likely to open up the very top of the market for the company and it should positively impact results in a visible way during the course of calendar year 2017.
The key for this company is going to be gross margins and their trend. If my surmise about the future of the price war bears out, and competitors start to focus a bit more on profitability than on market share, the opportunities for this vendor are significantly under-appreciated and under-valued. GAAP gross margins increased by 670 bps year on year and GAAP product gross margins increased a comparable amount to 67.3%, which suggests that the major impact of price competition is being held at bay. On the other hand, gross margins were down sequentially by more than 100 bps, and product gross margins declined by more than 200 bps in the last quarter. Some observers were concerned that this regression represented a more malevolent impact of the impacts of the price wars in the storage space. It is the bet one makes in investing in Pure. I think the slight downtick the company has forecast for the current quarter that ends on 10/31 is a function of the introduction of the FlashBlade product and not an estimate on the level of price competition in the market. I do think that the heavy debt load that is carried by Dell/EMC and the inevitable costs of merging two large organizations, is going to put some pressure on that company to improve short-term profitability and cash generation and that is likely to lead to somewhat less aggressive activities in terms of excessive price competition.
As mentioned earlier, there are some signs that the company is starting to achieve expense discipline at scale although the progress is likely too slow for some. The following changes are all expressed as percentages based on GAAP in order to look at the direction of actual expenses.
Research and development spending rose by 9.5% sequentially and sales and marketing spending rose by 4.8% sequentially. General and administrative systems declined sequentially. Overall, operating expense rose by 5.6% sequentially while total revenues rose by 16.4%. On the other hand, stock-based compensation expense has more than doubled year on year and growth in that category is showing no sign of slowing down. The increase in stock-based comp has been the single primary factor in the improvement in cash flow from operations. The company has forecast that CFFO will turn positive in the coming fiscal year and the trend supports that forecast even if the growth in stock-based comp starts to moderate.
A blog I recently read said that no company since NetApp has been successfully launched in the storage business and reached a billion dollars in revenue since 1992. Pure is forecast to reach that milestone next year. I think the odds favor that the forecast will happen and that it will continue to deliver consistent although not earth-shattering improvements in both CFFO and in non-GAAP earnings. It has become cheap enough for me to recommend purchase of the shares.
A (slightly) deeper dive into Nimble
I can't quite get myself to pull the trigger in terms of recommending Nimble shares. It is very cheap for a growth stock in terms of EV/S. It hasn't made money or generated cash or any of those things that would allow one to evaluate the shares on the basis of financials. I am going to discuss GAAP metrics as I usually do when looking at expenses. Gross margins, which is key for many people in looking at an emerging storage name, were 64.6% last quarter compared to 65.3% in the prior year. That is a decent performance given the introduction of the company's AFA product line. Product gross margins fell from 68.4% to 66.8% although the sequential trend showed an improvement of more than 100 bps in this most recent quarter. There were signs of expense control of some magnitude sequentially. Sales and marketing costs were flat sequentially although they were still up by 29% year on year. General and administrative costs were flat sequentially and were up just more than 10% year on year. Research and development costs continue to increase significantly and were up by almost 13% sequentially. At more than 30% of revenue, research and development expense ratios have to fall by more than 1,000 basis points before the company can see a clear path to profitability.
The company's most recent quarter was a solid beat. Revenues showed a bit of re-acceleration as the company started to enjoy the effects of the introduction of its AFA products. The company guided revenues slightly above the prior consensus but not enough apparently given the trajectory of the share price.
This company's raison d'etre is based on what it calls cache-accelerated sequential layout (CASL) which allowed the company to combine flash and hard drives to achieve optimal performance. Recently (the past prior quarter) the company released its all-flash product and that product was 17% product bookings growth compared to 9% in the prior quarter. The company's guidance anticipates the continuation of that trend and seems in line with overall market trends. Eventually the use of all-flash is going to have salutary impacts on gross margin. The company does not compete beyond the low-end of the storage market and its future success will be tied to developing and selling AFAs in the segment. The company did see an increase of 37% in bookings of deals from large enterprise customers and it saw an increase of 60% in bookings from deals greater than $250,000.
I think that there will always be a specialized market for this company's technology. It is more efficient to use any kind of storage based on caching and a form of predictive analytics which is the secret sauce this company embodies in its products. And I doubt that many competitors are going to choose to try to match Nimble's special sauce because its market is specialized and the company has spent hundreds of millions of dollars developing its operating system and the caching formula. It is going to win when it competes in the right use cases where its formula is uniquely valuable.
Like Pure, the company has a very high Net Promoter Score (that is the metric that the industry uses to measure satisfaction and the 85% grade is more than double what the other larger storage vendors typically achieve.) But this is more likely than not to remain a niche market. I think that the most likely prospect for Nimble is to get bought at some point along the way given its size and its valuation - but that is rank speculation on my part.
The company has wavered between positive and negative cash flow. Stock-based comp is 25% of revenues, one of the higher ratios around. On the other hand, it has basically stopped growing and since the company has to slow its research and development hiring which generates most of the stock-based comp, the ratio should start to improve over the next few quarters.
The company is forecasting a significant growth re-acceleration that would, were it to happen, take growth significantly higher than the numbers in the current consensus. Many of the factors that would lead to such a result are unknowable at this point. One might indeed hit a home run by betting that with Nimble's AFA now being extended to all segments of the market and with some decent indications regarding go-to-market strategy the stars are aligning. I just don't quite have the confidence in things working out that way as there has yet to be enough of an established revenue trend and the phrase about there being many a slip twixt cup and lip is quite operative.
Nimble hitting a home run - that is certainly possible but I like the risk/rewards inherent in betting on Pure a bit better where I can see what has been happening. There is lots of execution risk in restarting a growth engine once it has been allowed to sputter and I simply don't think there is enough information available to say that Nimble's secret sauce is going to be sold in this company's bottles over the long haul. But the valuation and the technology are such that it is a very real and very live consolidation candidate.
Disclosure: I am/we are long PSTG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.